FOMC Skips June, But Signals Hikes Not Done Yet

Summary of the meeting;

• FOMC unanimously decided not to raise rates at the current meeting.
• "Additional policy firming" may still be considered according to the Committee.
• Median dot for 2023 shifted up by 50 bps, indicating potential tightening by the end of 2023.
• Bond market previously expected only 25 bps of additional tightening.
• Unemployment rate forecast for year-end 2023 was lowered by the Committee.
• Outlook for core PCE inflation at the end of the year was raised.
• None of the 18 FOMC members think a rate cut by the end of 2023 is appropriate.
• FOMC does not require precise 2% core PCE inflation, but evidence of sustained progress.
• Anticipating a 25-bps rate increase at the next FOMC meeting on July 26.
• Acknowledging that the risks to the fed funds rate forecast are biased towards an increase.
• FOMC on Hold, But Leaning Toward More Tightening

As expected as well mentioned by me on this blog; https://acy.com.au/en/market-news/market-analysis/fed-to-pause-this-week-l-s-105116/, the Federal Open Market Committee (FOMC) chose to pause rates during its policy meeting on Thursday. This marks the first time in 11 meetings that the Committee has maintained the current fed funds rate (Figure 1). The decision to keep the target range at 5.00%-5.25% had unanimous support from all 11 eligible voting members. Additionally, the FOMC decided to maintain its current pace of quantitative tightening, allowing up to $60 billion of Treasury securities and up to $35 billion of mortgage-backed securities to roll off its balance sheet per month.

The post-meeting statement released yesterday showed minimal changes compared to the previous statement on May 3. The Committee reiterated that economic activity is experiencing modest growth, while highlighting low unemployment and elevated inflation levels. By keeping rates unchanged, the FOMC aims to gather additional information and assess its implications for monetary policy. The Committee restated its commitment to consider various factors when determining the potential need for "additional policy firming" to achieve a return of inflation to 2 percent over time. These factors include the cumulative impact of monetary policy tightening, the time it takes for monetary policy to affect economic activity and inflation, as well as economic and financial developments.

Figure 1: Federal Funds Target Rate

Source: Federal Reserve Board and Wells Fargo Economics

Figure 2: June 2023 FOMC Dot Plot

Source: Federal Reserve Board and Wells Fargo Economics

Dot Plot Shifts Up

Based on the Summary of Economic Projections (SEP) released by the FOMC four times a year, it appears that most Committee members believe that additional policy tightening may be necessary in the coming months. The "dot plot" from the March 22 meeting indicated that the median FOMC member considered a fed funds target range of 5.00%-5.25% appropriate by the end of 2023. However, the most recent dot plot shows a shift in the median dot to a range of 5.50%-5.75% by the end of this year (Figure 2). This suggests that the median FOMC member now believes an additional 50 bps of tightening will be required to achieve the goal of 2 percent inflation over time. Despite this, the bond market currently expects only one more 25 bps rate hike by the end of 2023, likely to occur at the July meeting.

What led to the change in the dot plot? The answer lies in the FOMC's revised forecasts for unemployment and inflation. As depicted in Figure 3, the unemployment rate remains exceptionally low, with the Committee now projecting it to reach only 4.1% by the end of 2023 (compared to the median participant's March forecast of 4.5%).

Furthermore, the median forecast for the core rate of PCE inflation at the end of 2023 has been raised from 3.6% in March to 3.9% currently. Interestingly, none of the 18 current FOMC members believe that a rate cut by the end of the year would be appropriate.

Figure 3: Unemployment Rate

Source: U.S Department of Labor and Wells Fargo Economics

Figure 4: Core PCE Deflator

Source: U.S Department of Labor and Wells Fargo Economics

What conditions would prompt the FOMC to consider easing policy? Unless an unexpected negative shock hits the economy in the coming months, the Committee will require evidence of sustained inflation returning to 2%. Although recent months have seen a slight decline in the inflation rate, only an optimist would interpret this as a sign of a return to 2% inflation (Figure 4). From my perspective, the year-over-year inflation rate doesn't have to precisely reach 2% for the Committee to consider easing policy. However, I forecast that the core PCE deflator will increase at an annualized rate of 2.8% in Q4-2023 compared to Q3-2023, which I believe is still too high to warrant rate cuts. Consequently, I don’t anticipate a rate cut this year, aligning with the current thinking of the FOMC.

The upcoming FOMC meeting is scheduled for July 26. Based on the economy's ongoing resilience and the persistently high inflation rate, I anticipate the Committee to raise rates by another 25 bps during that meeting (but this can change subject to data release up to July 26). Chair Powell himself mentioned in the post-meeting press conference that the July FOMC meeting will be a "live meeting." Following that, I expect the Committee to maintain the current rate for the remainder of the year. However, considering the latest dot plot, I acknowledge that the risks to my fed funds rate forecast are skewed towards potential increases. I believe that a modest recession early next year, which would help lower inflation, will be necessary for the FOMC to consider easing policy.

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